In the context of inspections carried out by the financial administration which focus on transfer pricing, we have registered an increasing demand for examining or ensuring compliance of interest rates on related-party credits and loans with the arm’s length principle. How are the interest rates determined in such cases?
The terms of loans and credits made available by related parties, including the interest rate, should comply with the arm’s length principle. As standard, this principle is used to assess the reasonableness of prices on services agreed between related parties. The applicable criterion is defined in Section 23(7) of Act No. 586/1992 Sb., on Income Taxes, as a price that would be agreed between independent parties in ordinary business relations in identical or similar circumstances or if any difference from any such price is substantiated with satisfactory evidence.
To substantiate the reasonableness of the interest rate, an expert assessment can be used as a supporting document for the financial administration.
The advantage of expert opinions is that they are more difficult to dispute by the tax administration which must act in accordance with the procedural rules set out in the judgment of the Supreme Administrative Court in case 7 Afs 86/2013 (including, for example, an examination of the expert, and a review expert opinion including the settlement of differences).
How interest rates are assessed or determined in such cases?
The method of assessing or determining interest rates in compliance with the arm’s length principle depends on the specific features of the case in hand. As a result, there is no universally applicable model that could be employed in all cases. At all times, the specific terms of a specific loan / credit must be assessed (such as currency, purpose, term, maturity, security, and subordination to bank loans). At the same time, an analysis of the debtor must be carried out, i.e. the company’s activities, assets and capital, solvency, estimated development and any expected changes.
In all cases, a major factor affecting the choice of the method of determining the interest rate is the source of financing, i.e. the fact whether it is a senior or a junior source. In the case of a senior loan or credit, the risk of default is assessed as the next step, based on the debtor’s estimated solvency/rating (this is made as an expert estimate similarly to rating agencies). Where a junior source of financing is involved, the method is slightly different. In such a case, we ascertain the value of how less risky the source (loan/credit) is than the debtor’s equity.
In certain cases, the Income Taxes Act provides for exceptions when a lower price or interest rate may be agreed below the fair market level without any adjustments to the taxpayer’s tax base being necessary. Section 23(7) of the Income Taxes Act provides that no adjustments apply to the tax base to a level that it would have reached if the parties had agreed a fair market price, provided that the agreed price for a loan is lower than the fair market price and the creditor is a member of a business corporation.
RSM Consulting SK Valuation has produced a number of surveys and opinions assessing compliance of interest rates with the arm’s length principle.
Please contact us for more information. We would be happy to advise you.